Thursday, January 1, 2015

Cashing up the system

David Beckworth had a very interesting pair of posts outlining how QE would only have had a meaningful effect on the economy if the associated monetary base growth was permanent.

One addendum I'd add on the topic is that even permanent expansions of the monetary base can have no effect on the economy. The best example of this is the "cashing up" of the Reserve Bank of New Zealand (RBNZ) in 2006, an event that doesn't get the attention that it deserves in monetary lore.

Banks typically hold deposit balances at their central bank in order clear payments with other banks. Because New Zealand's clearing and settlement system was suffering signs of stress in the mid-2000s including delayed payments, hoarding of collateral, and increased use of the RBNZ standing lending facilities, the RBNZ decided to 'flood' the system with balances to make things more fluid. This involved conducting open market purchases that bloated the monetary base (comprised of currency plus deposits) from around NZ$6 billion in mid-2006 to just under NZ$14 billion by December of that year. See chart below.

(Note that the RBNZ's problems began far before the credit crisis and were due entirely to the peculiar structure of the clearing system, not New Zealand's economy.)

This 'cashing up' of New Zealand's monetary system was fast, large, and permanent, so New Zealand should have experienced extremely high inflation, right? Actually, New Zealand's inflation rate was very reasonable and even declined a bit that year.

Why is that? As long as central banks are allowed to provide interest payments to depositors, permanent increases in the monetary base needn't have much of an effect on the economy. Like most modern central banks, the RBNZ pays interest to commercial banks that keep balances on deposit at the central bank. So even if a central banker permanently amps up the supply of balances, banks will not all simultaneously try to offload this excess supply and hyperinflation does not follow. This is because the deposit rate 'carrot' that is dangled in front of banks helps offset their urge to get rid of the excess. In fact, even as it was cashing-up the system the RBNZ increased its deposit rate by 5 basis points five times between July and October 2006 for a total increase of 25 basis points, a slight tightening of monetary policy. This brought the return on central bank balances to a level competitive with other assets like government treasury bills. Instead of panicking as the monetary base permanently exploded by 150%, New Zealand's banks shrugged and calmly accepted the new balances.

When central banks don't pay interest on deposits then a permanent increase in the base will typically have a large effect on the economy. Without an interest rate carrot to make deposits competitive with other assets, banks that are faced with large excess balances will race to get rid of them, causing a large spike in the price level. With the U.S. Federal Reserve only earning the legal right to pay interest in 2008, there are now no major central banks (to my knowledge) that lack their own deposit rate carrot. And all of them set that rate to be roughly competitive with the rate on other short term assets like treasury bills, specifically a few basis points below the rate on competing assets.

Just to make sure I've made my point, with the deposit rate on central bank balances being (almost) competitive with other assets, a permanent doubling in the supply of money will only cause significant inflation when combined with a large cut to the deposit rate. Keep that rate unchanged and the same doubling will only have a marginal effect on the economy. A doubling in the supply of money would actually be deflationary if combined with a large enough rise in the central bank's deposit rate. In short, central bank decisions about the deposit rate can override whatever permanent changes are made to the money supply.

Beckworth makes the case that the Federal Reserve's quantitative easing was never more than a temporary measure, and therefore had no meaningful effects on the economy. I agree with him that QE didn't have much of an effect, but not necessarily because it was temporary. Let's say that QE was not a temporary phenomenon but rather more akin to a permanent New Zealand-style 'cashing up' of the system. If so, would QE's effects on the economy have been more marked? Given the precedent set by New Zealand in 2006, I don't think so. Throughout the Fed's three QEs, the rate offered on Fed balances (generally referred to as interest on reserves, or IOR) was very competitive with the rate on other government-issued short term assets, and therefore banks would have been unlikely to feel any need to rid themselves of their rapidly growing pool of balances. So while I agree with Beckworth that the Fed's 'dirty little secret' is that QE was muted from the start, I don't think that this powerlessness necessarily hinges on QE being temporary—after all, permanent increases can fall on deaf ears, depending on the level at which the central bank's deposit rate is set. New Zealand is living proof of this.

PPS. I'm not sure whether he'll agree with the following, though. Take the RBNZ again. It's 2006 and the Bank is paying a competitive rate on central bank balances. When it cashes up the system, the RBNZ simultaneously announces a regime change; it will now target 4-6% inflation rather than 1-3% inflation. It also says that the permanent increase in the supply of balances (and subsequent increases if necessary) will be sufficient to ensure this target is reached. The threat of a lower deposit rate will not be used to enforce the target, the rate being left unchanged. Will the RBNZ manage to hit its new target? I say no. Despite a regime change and a commitment to permanent open market operations, the Bank won't succeed in doubling inflation. This is because the unchanged deposit rate will be set too high, interfering with the RBNZ's ability to carry out its promise.

Two of my favorite posts that went pretty much under the radar screen were Fear of Liquidity and Liquidity Everywhere. Ignoring the fact that these titles sound like adverts for diapers, do give them a read.

Thanks to all you who comment on this blog. It's always fun to read your thoughts, they get me thinking about the next post.

28 comments:

Excellent points. Of course the central bank would only be able to make interest payments if its assets had risen in step with its issuance of new money. It would be nice, empirically, if we could observe central banks whose assets grew faster, slower, or the same as their issuance of money, and watch what happens to their inflation rates.

If the central bank is obliged to at least break even (i.e. interest on reserves shouldn't exceed the safe overnight lending rate), then it can't arbitrarily increase the monetary base. As we've seen with the Fed, interest on reserves doesn't put a floor on interest rates.

So this seems incomplete to me without talking about how seignorage was affected by the increase.

You're right, interest on reserves would be a floor if everyone could hold reserves, not just banks. There's still a limit to the size of the monetary base, if only because one size doesn't fit all - people want to hold a variety of financial assets, not just MZM. It's a very large limit, though.

I think the real issue is not if the expansion is temporary or permanent but if the central bank has the ability to undo the expansion. If they buy assets that hold their value, so they could later be sold to withdraw the money, then the money need not lose any value (no inflation). In other words, I think the quantity theory of money does not always hold. For example, the East Caribbean Central Bank pegs the EC dollar to the US dollar at 2.6882 EC per US dollar. They can print all the EC dollars they want without inflation because they sell them at this price because they can always withdraw them later.

The big trouble comes when the central bank is buying long term government bonds. These can drop in value so that they can not be sold for as much as they were bought for. Then the central bank is not able to withdraw the expanded money. Then the value of the money can drop and there is nothing they can do. This is "the backing theory of money". The Quantity Theory of Money seems to work reasonably well for the case of buying the local government long term bonds.

I am convinced that Japan is expanding their money supply but will not be able to withdraw the new money. They are buying long term bonds at artificially low interest rates. The long term bonds would have a much higher interest rate on a free market and much lower prices. If they really tried to sell these bonds they would sell for far less than what the bank paid for them.

Are you willing to make any predictions on Japan? Is their expansion permanent or could they undo it? Will they be getting high inflation?

Oh, I see Mike Sproul has commented as well! He is the expert on the backing theory. I trust that theory more than the quantity theory of money as it seems to fit the experimental evidence much better.

The quantity theory is just an approximation which happens to work reasonably well often. The equation of exchange is always true. In this case there is changes in velocity which sort of always makes it work. But the backing theory really explains things and lets you predict what is going to happen.

If we look at Japan, they have about doubled their money supply but the value of the Yen is not half, so far. So the quantity theory is not holding. The equation of exchange can handle it with a change in velocity. The backing theory can handle it too. And backing the currency with the future value of the currency (which is what using a 30 year bond in Yen to back Yen is) is a bad plan. The kind of plan that fails again and again.

Yes, the RBNZ adopted a floor system, 'cashing up' is their wording. Was QE any different? Apart from the language used to package QE, the actual underlying steps look very much like the RBNZ's cashing up of the system.

Yes - operational implementation of the change itself has to be similar. That's only because the CB balance sheet must expand, other things equal, under either objective.

But a BIG difference in motivation and intention, as I recall.

(I do suffer from lack of re-research here).

As I read it, the purpose of a floor system is to liberalize the daylight overdraft concept. It is a purely operational advantage in a "normal" environment (a fortiori in an abnormal environment).

QE has much broader strategic objectives.

Also, the Fed's version of QE anticipates exit from QE, whereas a floor system is a permanent regime change by normal construction. There is no reason for exit and no reason for debate about exit from a floor system.

Reminds me though - I always wanted to do a post along the lines of QE as a floor system on steroids.

JKH, assume that a central banker is setting the deposit rate very close to the rate on competing short term debt. He announces that he will permanently cash up the system and says it won't cause inflation (like in NZ). Or he announces that he will permanently cash up the system and says it will cause inflation (like QE). It seems to me that only one of these forecasts can be correct. Which one? And if both have an equal shot of ending up being right, that means that mere words determine the efficacy of a policy.

Vincent, my guess is that if the RBNZ had bought local bonds instead it wouldn't have made much of a difference. That inflation hasn't taken off in the US, UK, or Japan is pretty good evidence as the central banks of these countries are all buying government bonds. But I am familiar with the argument that the price level can be unstable if a central bank owns assets denominated in its own currency. And I am also familiar with the fact that monetization of debt, especially at advantageous prices to the government, has caused inflation many times in the past.

If NZ buys US bonds and later sells them it does not really impact the price level (or interest rate) for US bonds much and so can probably get out for about the price it got in and so not hurt the backing for NZ dollar. It can be undone.

Japan has been buying 5 year bonds at 0.03% interest and 30 year bonds at 1.23% interest when nobody else is buying bonds. Even at these low rates a sizeable portion of Japanese taxes go to interest since debt is 240% of GNP. The government is spending about twice what it gets in taxes. If the bank tries to sell their bonds, while the government keeps selling bonds equal to the total taxes, interest rates would go up much higher. It can easily be that interest on the debt is more than total taxes and so there would be no buyers at any reasonable interest rate. Japan would have no chance of selling these bonds for anything close to what they paid for them and probably no real chance at all of selling them. They are the market for buying JGBs and they have greatly distorted the price.

Seems like the times in the past, Japan is all set for high inflation.

A floor system is a monetary operation design, not a monetary policy strategy.

A change to floor system is intended to be a permanent change in operational design.

QE is a monetary policy strategy that is not intended to be permanent - as currently implemented and envisioned by the Fed, notwithstanding wishes by many to the contrary.

A floor system does not necessarily vary the size of the floor reserves in any materially significant or interesting way, once implemented.

QE does - on the way up and on the way down.

Efficacy of the design/policy depends on the objective in each case.

The objective of the floor system is to smooth day to day operations of the clearing system, relative to the demand for daylight overdraft. It operates continuously in its real time effect over the shortest of durations.

The objective of QE is strategic, operating as currently implemented over an extremely long cycle. It is not intended to be permanent, although some think it should be.

One structural similarity is the requirement to pay an interest rate at the intended lower bound (or in that general area) for interest rates. The interest rate paid on reserves will rise for QE, just as it would for a standard floor, when the Fed gets around to increasing rates.

One question is whether or not QE will eventually become a standard floor system as the end game (post "exit"), instead of reverting to the previous scarce excess reserve system where IOR is zero as previously was the case. A lot of people seem to think so. But the Fed hasn't said so.

I think those are my main points of comparison. The efficacy of QE in terms of its effect on inflation or whether or not it should become permanent are separate issues of policy, IMO.

A standard floor system really has nothing directly to do with inflation policy. Floor reserves are quite contained by design, relative to QE magnitudes.

I'd quibble with the idea that QE is by definition temporary. David Beckworth points out that Japanese QE is pretty high up on the permanency scale (link) So let me rephrase my question:

Assume that a central banker is setting the deposit rate very close to the rate on competing short term debt. He announces that he will permanently cash up the system and says it won't cause inflation but is intended to make the clearing system more fluid (like in NZ). Or he announces that he will permanently cash up the system and says it will cause inflation (like Abenomics QE). It seems to me that only one of these forecasts can be correct. After all, the concrete steps being taken are exactly the same. Which one will be correct?

Vince, the assumption is that government bond markets are very large and liquid, so the RBNZ basically buys New Zealand sovereign debt at market prices. If prices move even a little bit away from fundamental value as a result of RBNZ buying, profit maximizing hedge funds, bond managers, and sovereign wealth funds take the other side of the bet, pushing them back into line.

JP, good post. I had forgot I had written that earlier post you mentioned in the post where I spell out the what would happen in a brave new world of IOER. I am thinking more about this and will take another look at the Peter Ireland paper where he argues even with IOER, the long-run quantity theory holds.

Oddly, I have to agree with JKH on QE being temporary by design. What is being done in Japan is a monetary regime change, not QE. They have explicitly adopted a higher inflation target and are throwing large scale asset purchases as a way to get to their new target. A standard QE program, on the other hand, has typically been associated with the same monetary regime and therefore must be temporary by nature.

I'd say that a standard floor system for operational purposes includes no direct element of inflation or price level policy. There is no joint announcement of such a policy. The two purposes are separate from each other. And if there is an inflation consequence, it is an unintended or secondary consequence.

And if there is an unintended or secondary inflation consequence from a floor system implementation, it should be relatively immaterial due to scale. The scale of a permanent floor system reserve injection would generally be much smaller than a committed QE program. And the fact there there is no announcement of such an associated inflation policy should mean that expectations won't be encouraging such an unintended consequence.

" If prices move even a little bit away from fundamental value as a result of RBNZ buying, profit maximizing hedge funds, bond managers, and sovereign wealth funds take the other side of the bet, pushing them back into line."

The Bank of Japan is buying bonds equal to about twice the total taxes each month. Hedge funds can't compete with this scale of money creation.

JP, it seems like you are saying the central bank can not distort the price of bonds. But if you mean that then you would also mean that the central bank can not change interest rates. I find few people with that view. Do you think Japan is not controlling interest rates and that the natural market rate for 5 year Yen denominated bonds is 0.02% per year? Note the Yen has been dropping fast, so it would seem to me it would take a higher rate to get people to buy them.

"The scale of a permanent floor system reserve injection would generally be much smaller than a committed QE program. "

JKH, is size relevant? NZ's cashing up of the system increased the size of the RBNZ's balance sheet far more than the Fed's QE1, for instance.

I'll ask you the same thing I asked David. Say that instead of calling its 2006 balance sheet expansion a 'cashing up' the RBNZ had called it quantitative easing. And it declared that the inflation would rise as a result of this expansion. Other than these differences in terminology and wording, its actions would be entirely the same under both scenarios. Would one result in a different outcome from the other?

Vincent: "But if you mean that then you would also mean that the central bank can not change interest rates."

No, a central bank can change the entire range of interest rates. But it does so by directly altering the rate on its own deposits, not by directly altering the rates of those assets that it purchases. In the moments after the rate on central bank deposits has been altered, arbitrage forces begin to act on all other interest rates in an economy, but this is a secondary effect arising from the initial change being made by the central bank's to its own deposits.

JP, in QE the central bank is buying the long term bonds on the open market. It is not just changing the rates on reserves held at the central bank. So the prices on bonds and interest rates are changing from this huge buyer in the bond market. The Bank of Japan is the only buy and hold buyer at this time. It sets the bond prices directly. It is not a secondary effect.

"Vincent, the backing theory and quantity theory are NOT mutually exclusive."In certain cases, yes. If the central bank issues 10% more money with no change in its assets, then both theories imply 10% inflation. It's when the central bank's assets are going one way while its issuance of money goes the other that the theories have different implications. Or if private banks issued 10% more money while the assets and liabilities of the central bank were unchanged, then the QT implies 10% inflation while the BT does not.